There’s a good chance that you’re not thinking about your startup’s books…unless you’re starting up a third-party accounting business. And while bookkeeping may not be as urgent as securing financing and real estate or purchasing inventory, it’s still a crucial part of running a business. Today, we’re looking at how to choose the right accounting method for your business and what you need to do monthly to keep your books on track.
CHOOSE AN ACCOUNTING METHOD
Cash Basis Accounting
The cash basis accounting method is the most popular accounting method for most startups because it is also the simplest. It involves recognizing income when it is received and expenses when they are paid.
Take, for example, a construction company. A customer signs a contract for $320,000 and makes an $80,000 deposit. The company recognizes $80,000 in income because that is how much cash was received. On the same day, the company recognizes $20,000 in expenses for materials that were purchased the month before.
Accrual Basis Accounting
The accrual basis accounting method recognizes revenue when it is earned and expenses when they are incurred. Using the same example as above, the construction company would not recognize the $80,000 in revenue until 25% of the project was completed.
Under accrual accounting, no income can be recognized until it has been earned. The $20,000 in expenses would have been recognized during the prior month when the materials and a bill were received.
The accrual basis accounting method is best for startups who perform ongoing service-based projects or carry a lot of inventory. It’s also the method required by the IRS for income tax filing for most corporations averaging over $25 million in gross revenue annually. Once your startup grows to this point, you must file your income taxes using this method even if you keep your books using the cash basis method.
UNDERSTAND THE IMPORTANCE OF EACH FINANCIAL STATEMENT
The Income Statement
The income statement, known as the profit and loss or P&L statement in certain industries, is arguably the most important financial statement for startups. It shows how a business is faring during a given period of time. This financial statement is most often generated at the end of the fiscal month, quarter and year.
Avitus Group offers a free Income Statement Template that you can download here.
The Balance Sheet
While the income statement is like a movie summarizing a business’s income and expenses for several weeks or months, the balance sheet is more like a snapshot–a picture capturing a moment in time. The income statement tells you how profitable your business is. Your balance sheet offers insight into how liquid your business is and how much it is worth. While the income statement shows revenue earned or received and expenses incurred or paid, the balance sheet shows all assets owned by the business, all liabilities owed by the business and all equity on the books. You should run this report monthly, too.
The Statement of Cash Flow
The statement of cash flow is important for startups who choose the accrual basis method of accounting. It reveals how much cash entered and left your hands over a given period. For example, the construction company in the examples above that used the accrual basis accounting method would see a net loss of all expenses incurred, like payroll, utilities, materials and rent that were incurred for the month. The deposit received could not be recognized until that percentage of the project was completed and not all incurred expenses would have been paid during the month.
However, that is not an accurate representation of cash coming in and going out. The cash basis accounting method is the only accounting method that accurately reflects cash flow. Using the above construction company example, there would be a net increase to profit (and cash) of $60,000 reflecting the $20,000 paid on materials and the $80,000 received but not yet earned. The statement of cash flow shows a business owner how liquid his company is and helps him make smarter business decisions. This report may be run weekly if you keep your books using the accrual basis accounting method.
The Statement of Owner’s Equity
Sometimes known as the statement of shareholder’s equity, the statement of owner’s equity is one of the most important financial statements for potential investors. When you compare the statement of owner’s equity between two periods, you can see if the business is growing in terms of assets increasing without financing. It is one of the most important reports for potential investors to look at to see if your startup is worth investing in. It is usually run annually, but some companies opt to run it quarterly.
WHY YOU NEED AN ACCOUNTANT
You may be able to keep up with your own bookkeeping on a weekly basis—especially when you’re first starting out. Still, every business of every size needs a CPA, or Certified Public Accountant. Even if you’re confident you have enough time to do your own books, we still recommend meeting with a CPA to answer crucial questions like which accounting method you should use, which depreciation method you should use or what expenses you could write off.
If the CPA you meet with clearly articulates the answers to your questions, ask her/him if she/he would be willing to work with you once a month on analyzing your financial statements.
Pro tip: A CPA will help manage your books, but you’ll still need to find a business tax specialist to handle your taxes at the end of the year.
When a Specialist Isn’t Necessary
You’ll certainly want someone with experience to file and pay your 940s and 941s (payroll taxes). However, there is no need to hire a tax specialist to file your ST-3s (Sales and Use taxes). Each Department of Revenue’s website thoroughly documents what revenue is assessable and how frequently a company should file and pay their Sales and Use taxes. Check your state’s Department of Revenue website for more details.
THE BOTTOM LINE
As a small business owner, you have enough on your plate without fussing over every tiny detail in your financial statements. As an owner, financial statements should be viewed as a necessity to ensure your startup is moving in the right direction—not something that takes hours from your work weeks.
If you’ve never built a financial statement from scratch, download our Balance Sheet Template and Income Statement Template. Just make sure you use specialists when necessary for decisions such as determining the right accounting method for your business and for filing your payroll and business income taxes.